If you are called in for an IRS audit, you will be asked to bring documentation to support the deductions being audited, which requires a little pre-audit preparation.
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The letter will detail a list of the deductions they wish to examine. The first thing you should do is get out your copy of the tax return, if you cannot locate your copy, contact the tax pro who prepared your return and request a copy.
Next, total your receipts for the deductions in question and compare the results to the figures on your tax return-- hopefully everything matches. If they dont, determine the difference then review your bank statements, credit card statements, and check registers to locate additional expenditures. If you cannot find the difference then that amount will likely be disallowed as a deduction.
If you can get a copy of a missing receipt before the audit, thats the best option, if not, a picture of the item may suffice. A picture may come in handy when you are writing off major assets like refrigerators and stoves for a rental property or furniture, equipment, and fixtures for your business. Of course, proving that you made the purchase during the year in question may be difficult.
Now that youve rounded up all of your receipts, the auditor will confirm the amount of the deduction and if it is valid. For example, you have a copy of your cancelled check made out to the American Cancer Society. IRS regulations dictate that you must have a letter from the nonprofit confirming that the amount donated was in fact a donation. It could be that the $500 you donated to PBS included the fair market value - $100 for Tina Turners concert in Barcelona DVD. If that is the case, then you should have written off only $400 as a charitable contribution. Here comes an adjustment to your tax return. Keep those thank you letters in your tax file; if you dont have one, the auditor may disallow the entire amount.
Many deductions are straight forward and normally dont get a second glance once a cancelled check or paid receipt is produced: property taxes, vehicle registration fees, medical expenses (although reimbursement from insurance companies is examined), state income taxes withheld and paid are good examples. The receipts most often questioned have to do with expenses that involve fun activities or where personal, non-deductible involvement might be a factor: travel, meals, entertainment, vehicle expense, home office and certain other business expenses.
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If you have expenses to defend that fall into the above categories, read up on the rules or discuss these expenditures with your tax pro before going into an audit. You may discover things that surprise you. For example, you cannot write off your vacation just because you dropped off a couple of resumes at a few businesses near the hotel. Or, that the big client Christmas party you threw is also not deductible.
If you use your vehicle for business, and you took actual expenses rather than mileage, having a batch of receipts for fuel and repairs will not suffice. The auditor will want a log of your business miles and total miles driven during the year. This may be something you will have to create. Although the IRS code requires that you keep a contemporaneous log, I have yet to meet an auditor who did not accept a reconstruction. This is why I urge taxpayers to record their beginning odometer and ending odometer readings for the year. This will provide the total mileage figures required on your tax return. MapQuest is a great help in reconstruction. For more information on this topic click here
Audit-speak is important: Auditors understand when you speak their language. Comprehending the meanings and using key phrases will help you unravel the code and better defend yourself in audit. Here are the most important:
1. Intent. Intent is a factor for determining the validity of deductions. For example, if you are defending a trip to Maui, which was primarily a vacation with a bit of business mixed in the form of having lunch with a business contact, the lunch will likely be allowed but the accompanying travel expense will be disallowed because the primary intent was vacation. But if the purpose of the trip was to buy Hawaiian artifacts to sell in your store and you have correspondence between yourself and various vendors as well as receipts for items purchased then you will likely be allowed the full deduction. It boils down to intent--the primary purpose of the trip. This maxim can be applied to all business deductions. So if this is the case, merely say: The intent of the trip was business.
2. Not lavish or extravagant. This phrase is often used to describe the acceptability of meals, entertainment and travel deductions. It can also be weighed against your finances in general. If you are Donald Trump there is likely nothing that would be considered too lavish or extravagant. But if you maxed out your credit cards to fly your best clients (who also happen to be your best friends) to Scotland to see a U2 concert and then had the costs discharged in your bankruptcy, you were being both lavish and extravagant. The deduction will be disallowed. Telling an auditor who questions an expensive meal I had to land this client. It was a really big deal; considering the circumstances and the competition I was up against, this was not at all lavish or extravagant.
3. Ordinary and necessary. This term describes the acceptability of business expenses in general. The IRS doesnt have a set of expenses that are allowed for business purposes simply because every industry has different requirements. If you are in the food preparation business, you may need a $5,000 espresso maker. An insurance broker, however, would not need such a device, So if you own a limousine service, you can say: Yes, thats right, Mr. Auditor, stocking champagne in the limos is an ordinary and necessary business expense.
4. Reasonable Cause. This is a phrase normally used at the end of the audit. If you pretty much blew it when preparing your tax return, and the entire audit turned out to be a great learning experience, which means you owe beaucoup bucks, you may be assessed penalties. You may have these penalties removed if you have reasonable cause. Think of the reasons why you goofed on preparing your tax return. Perhaps you relied on an incompetent bookkeeper, or had another very good reason for goofing up, then you may persuade the auditor to abate penalties. This can save you a lot of money.
Speaking of abating penalties, next week I will discuss potential penalties, how to have them removed and what to do next if you are not satisfied with the audit results.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know, available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.